An important step in the implementation of investment policy is the acquisition of prudent and suitable investments. Investors choosing to diversify their investment positions both within and across asset classes [1] often select pooled investment vehicles like mutual funds or exchange traded funds. Inevitably they must address the question: “what funds should I buy?”
Each year, SCLC [2] develops an annual fund evaluation report. We refer to this report, somewhat tongue-in-cheek, as the antidote for the Morningstar/Lipper/Money Magazine type of approach that often rates investments as if they were restaurants. The report summarizes our analysis and opinion regarding investments as of December 31st of the previous year. Specific reports detailing individual investment holdings are sent to each client; and, we retain a master list for in-house reference.
How do we use our master list? Let’s say that a client wishes to own a position in the U.S. bond market. That is to say, a client wishes to expose x% of wealth to the returns and risks of the aggregate U.S. bond market. What is the best way to do this?
Generally, an investor has the choice of buying an actively managed fund that invests its assets in the general U.S. bond market, or a passively managed fund designed to replicate a benchmark index of U.S. bonds. Let’s say that you have done some preliminary research and have narrowed your choice to three funds:
1. The Vanguard Total Bond Market Index Fund—a passively managed index fund [3];
2. The Fidelity US Bond Index Fund—a passively managed index fund; and,
3. The PIMCO Total Return [4] Fund—an actively managed fund
Each of the funds measures its performance against the Barclay’s Capital U.S. Aggregate Bond Index (formerly, the Lehman Brothers’ index), and each has a good performance track record.
The PIMCO fund has been managed by Bill Gross since its inception in May 1987; and, statistical tests suggest that Mr. Gross is a skilled manager that, at an 80% confidence interval, has outperformed the Barclay’s comparative index. Quite simply, the investor can be reasonably certain that Mr. Gross beats the market because of his investment skill rather than mere luck. The Vanguard Index fund seeks to track the Barclay’s bond index as closely as possible. The effectiveness of the Vanguard index construction and cost control strategies is apparent. Over the period January 1987 through December 2009, investors received the return [5] of the paper index with only a two-basis point negative tracking error per month.
Over the period April 1990 through December 2009 the Fidelity US Bond Index Fund also tracked the paper index with only a one-basis point negative tracking error per month. This is just about as close to the index as a live fund can get. In short, the statistical profile of each fund looks very attractive. SCLC deems that each fund is a prudent investment. So what’s the big deal—if you want to try to beat the market, buy the PIMCO fund, if you want to track the market, buy one of the index funds. They all look good. However, there is more to the story.
Here are excerpts from SCLC’s narrative description of each fund:
Vanguard: The Vanguard Total Bond Market Index Fund seeks to track the performance of the Barclays Capital U.S. Aggregate Bond Index. The Fund is constructed on a “stratified cell” sampling method, and does not attempt a full replication of the index. At least 80% of the Fund’s assets will be invested in bonds held in the Index. The Fund maintains a dollar-weighted average maturity consistent with that of the Index, which currently ranges between 5 and 10 years. The Fund may invest in derivatives only if the expected risks and rewards of the derivatives are consistent with the investment objective, policies, strategies and risks of the Fund. Derivatives will not be used to change the risk exposure of the Fund.
Fidelity: The Fidelity US Bond Market Index Fund seeks to provide investment results that correspond to the total return of the Barclays Capital U.S. Aggregate Bond Index. The fund will generally invest at least 80% of its assets in bonds included in the underlying index. It employs a representative sampling indexing strategy, and does not attempt a full replication of the aggregate bond market. The Fund may engage in transactions that have a leveraging effect. Such transactions include investments in derivatives, regardless of whether the fund may own the asset, instrument or components of the index underlying the derivative. Fund management reserves the right to “invest a significant portion of the fund’s assets in these types of investments.” The fund may also employ trading strategies involving sales and repurchases (at a later date) of mortgage securities. This strategy may increase the fund’s interest rate exposure.
PIMCO: The PIMCO Total Return Fund seeks maximum total return, consistent with preservation of capital and prudent investment management. The Fund invests, under normal circumstances, at least 65% of its total assets in a diversified portfolio [6] of fixed income instruments of varying maturities. The Fund invests primarily in investment grade debt securities, but may invest up to 10% of its total assets in high yield [7] securities (“junk bonds”) rated B or higher by Moody’s or S&P, or, if unrated, determined by PIMCO to be of comparable quality. The Fund may invest up to 30% of its total assets in securities denominated in foreign currencies, and may invest beyond this limit in U.S. dollar-denominated securities of foreign issuers. The Fund will normally limit its exposure to foreign currency risk to 20% of its total assets. The Fund may invest all of its assets in derivative instruments such as options, futures contracts and swaps. It may also employ strategies such as “buy backs” and “dollar rolls” that involve contracts to purchase (sell) mortgage securities while simultaneously agreeing to a future repurchase at a pre-determined price. Under certain circumstances, the Fund may enter into short sales. These transactions may significantly increase the Fund’s risk exposures.
Whoa! What is going on here?
It seems that not all bond funds are created equal. Investors generally recognize that active managers do not like to be tied down by conservative strategy limitations that restrict their ability to beat the index. Most investors understand that a successful track record by an active manager is never a free lunch. Investors hope that they will not be blindsided in the future by a series of poor bets made by the fund manager. However, investors may be surprised to learn that even some index managers like to write themselves a “blank check” when it comes to risk exposures.
For the quarter ending June 30, 2009, bond mutual funds (exclusive of exchange traded funds) drew net inflows of almost $90 billion. Some commentators remark that the inflow is a byproduct of low money market and CD rates. This suggests that bond buyers may be chasing yield. If this is the case, SCLC hopes that they have taken the time to read the prospectus [8]. The “fine print” language about permissible uses of derivative instruments may be important if, in some wild set of circumstances, the nation plunges into a liquidity crisis combined with a plunge in housing-related security values, lowering of credit ratings for muni-bond issuers, high federal deficits, etc.
As stated, in the instant case, SCLC indicates that each of the three bond funds is a prudent investment position—investors have received rewards commensurate with risk. However, investors have differing levels of risk tolerance and may wish to dial risk up or down depending on their economic circumstances and objectives. SCLC defines its job primarily in terms of disclosing information to clients so that they can make intelligent choices rather than making “recommendations” based on compensation agendas, vendor relationships, or other factors that could undermine fiduciary [9] responsibilities. Some of our clients own Vanguard, some Fidelity and some PIMCO. The only “bad” choice is an uninformed choice.
One thing’s for certain. Selecting an investment based on current yield or realized track record is not a good strategy. It’s important to understand what is in the prospectus and to be comfortable with the investment powers claimed by the fund manager.
My publications in this area include:
Patrick J. Collins Ph.D., CLU, CFA “Monitoring Passively Managed Mutual Funds,” The Journal of Investing (Winter, 1999), pp. 49-61; and,
Patrick J. Collins, Ph.D., CLU, CFA “‘Without More’: Trust Investment Manager Selection and Retention Policy,” The Banking Law Journal (May, 2008), pp. 391-456.
Please contact me at patrick@schultzcollins.com if you would like to see a sample of a full report for an individual fund or a reprint of an article.
Cordially,
Patrick J. Collins, PhD, CLU, CFA